Market Roundup - April 2013
April: Lack of pullback doesn’t mean lack of concernBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
Consensus in the market going into March seemed to be that a stock market pullback was inevitable. But even a botched and confusing bailout of Cypriot banks by the eurozone leaders couldn’t trigger the inevitable. The market just took it in stride and kept going higher. We’d urge caution, though. Just because the market didn’t react negatively doesn’t mean the coast is clear. The Cyprus bailout will likely have a long tail, meaning that its full effects may be felt over time, as public support of more bailouts and more austerity in Europe dwindles. With U.S. central bank support, bond investors could see yields stay low, while U.S. equity markets could stay supported.
The economyBy Brian Jacobsen
The big news in March was the Cyprus bailout. Initially, all depositors—insured and uninsured—faced losing a good chunk of their bank deposits. Thankfully, the possibility of massive bank runs caused officials to back away from that plan. Instead, the eurozone-member country is scheduled to receive a bailout that only uninsured depositors, equity holders, and bondholders in Cyprus’ banks stand to lose money on.
The Cypriot government has had to impose capital controls to keep people from withdrawing money and leaving the country. Although Cypriot officials claim that these controls will only last a few weeks, they could last much longer if history is any guide. It’s been more than four years since Iceland first restructured its banks, and it still has some capital controls in place. Asian and Latin American countries kept capital controls in place from half a year to two years after their banking crises of the latter part of the 20th century.
The problems in Cyprus may affect the political and economic landscape in Europe. Economically, the banking system is contracting as bank lending falls. European banks were relatively less reliant on deposits for funding than their U.S. counterparts, making the European banks more vulnerable to changes in credit conditions in the financial markets. Now that uninsured deposits are clearly at risk—even insured deposits could be at risk—it would not be surprising to see the deposit base of European banks shrink. That could lead to a further contraction in bank lending and increase the vulnerability of European banks.
Politically, the prospect of taking voters’ money is not a winning agenda. The Cyprus experience may foil the austerity plans and bailouts that seem to go part and parcel with being in the eurozone today. Poland will have a referendum as to whether it becomes the 18th member of the eurozone. Italy is in the midst of trying to form a government. Considering that the president of Italy’s term is up in May and he cannot call for new elections, voters may express their solidarity or disgust with the euro in elections this summer. In the meantime, we think it is wise to err on the side of caution when looking at investing in Europe.
Japanese equities have been on a tear since the election in late 2012 that brought back into power the Liberal Democratic Party. Shinzo Abe, the head of the party and country, has been vocal about getting Japan to return to inflation rather than stay in deflation. The appointment of Haruhiko Kuroda as head of the Bank of Japan (BOJ) underscores Abe’s commitment to this goal. The yen has weakened significantly and the stock market has risen, both on speculation about what the BOJ might do. We fear that the bar has been set too high and the BOJ may not live up to expectations. While the country may hit its 2% inflation target, it might be slow getting to that number. Decades of deflation—and how that experience has embedded itself into people’s expectations—don’t change in a few months.
The U.S. looks like it is holding up pretty well. In fact, economic growth for the first quarter may be significantly higher than we—and many—were expecting. Most indicators suggest that instead of struggling to get above 1% growth in gross domestic product (GDP) for the first quarter, GDP growth could be closer to 3%.
Income was hit hard going into 2013, declining 3.7% in January. February rebounded nicely, up 1.1%. Consumption, however—as we expected—stayed fairly consistent, up 0.4% in January and 0.7% in February. January’s decline was partially due to a surge in dividends in December. Disposable income (income after taxes) declined significantly because of the expiration of the two-percentage-point payroll tax holiday. There was no drop-off in spending because consumers like to smooth out their consumption over time, even if income is volatile.
The volatility in income coupled with high gasoline prices did show up in falling consumer confidence measures. Despite the lack of confidence, consumer spending is likely to rise at the fastest pace in two years in the first quarter. In the U.S., manufacturing is firming and housing is recovering. Durable goods orders increased 5.7% in February, mainly because of a strong rebound in defense spending and airline orders. New home sales declined 4.6% in February, but that was after a 13% jump in January. Prices are also up 8% year-on-year. Mixed with a supportive U.S. Federal Reserve (Fed), we think the U.S. is perhaps the best place to be looking for investment opportunities now.
EquitiesBy John Manley
The first quarter of 2013 ended on Easter Sunday. However, for the U.S. stock market in that period, the proper mascot wasn’t Peter Cottontail. It was the Energizer Bunny: It just couldn’t (or wouldn’t) be stopped.
Despite tax increases, spending cuts, Cypriot implosions, and Chinese swoons, investors in U.S. equities poured money into the market and pushed both the Dow Jones Industrial Average and the S&P 500 Index to new all-time closing highs. Aided by signs of life in the U.S. housing market and corporate profits that refused to fall on cue, many of the popular equity measures had double-digit increases in the period.
It was a lesson in risk management. In our opinion, last year ended with many investors focused only on one risk: the possibility of being invested in stocks when the equity market falls. The past three months have brought a growing realization that there is another risk: that of being parked in risk-free and return-free assets or the risk of being out of the equity market when it goes up.
We may be in the throes of a buying panic as more and more investors perceive the riskiness inherent in their risk-free investments. Some exhilaration may be in the market, and a few potholes may be on the way. Still, with consensus estimates of forward price-to-earnings ratio under 15 times, the Fed showing no signs of tightening policy until clear and strong indications of sustainable economic growth appear, and the yield of the S&P 500 Index close to that of the 10-year Treasury note, it is probably not too late to obey that old Wall Street adage: “If you are going to panic, panic early.”
In March, the S&P 500 Index advanced 3.8% and the Dow Jones Industrial Average gained 3.9%. These numbers capped quarterly gains of 10.6% and 11.9%, respectively. The Nasdaq Composite (now burdened with Apple) lagged slightly, adding 3.5% and 8.5% in the month and quarter, respectively. Growth and value fared about the same in March. The Russell 3000 Growth Index gained 3.9%, while the Russell 3000 Value Index advanced 4.0%. In the quarter, value outperformed by 250 basis points (bps; 100 bps equals 1.00%). Small stocks did marginally better than large stocks in both the month and the quarter. The Value Line Composite Index (arithmetic) advanced 4.3% and 14.2% in those respective periods.
All of the S&P industry sectors advanced in both the month and the quarter. The best-performing sector in both periods was health care. The area rose 6.4% in March and 15.8% in the first quarter, and Wall Street began to admit that the Affordable Care Act may be injecting money into the industry. The second best performer in the month was the utilities sector, with a 5.4% gain. That sector also outperformed in the quarter, with a 13.0% appreciation.
It is interesting to note that early cycle sectors generally outperformed. Besides health care and utilities, the consumer staples and consumer discretionary sectors both outperformed the market in March, each with 4.9% gains.
Heavy cyclicals and commodities generally underperformed. The worst performer in March was energy, which appreciated 9%. In addition, industrials, information technology, and materials gained less than 3% in the month, due perhaps to weakness in Europe, stagnation in China, or uncertainty in Latin America. Whatever the cause or causes, mid- to late-cycle groups were all near the bottom of the performance pack.
The market joy in the U.S. did not extend to the majority of foreign exchanges. With the exception of a 10.9% surge in Argentine stocks, all of the major emerging markets declined in March. China did the worst, with a 5.5% drop, but with a decline of 5.2%, Russia was a close second. Both India and Mexico showed fractional declines. In Mexico’s case, a strong peso created a 3.5% gain in U.S. dollar terms.
Developed countries did a bit better, but the cloud created by the crisis in Cyprus clearly had an impact on the markets. Ireland was the exception, with a 6.1% jump. Switzerland rose 3.5%, perhaps as a safe-haven alternative to Cyprus. France and Germany rose fractionally. The biggest loser was Greece (down -13.5%) as Cypriot issues brought unhappy memories to light. Italy and Spain both fell 3.7% on fears of fallout. Japan continued to be strong. That market rose 6.7% in March and 18.7% in the first quarter. Investors seem to have bought into the notion that a weak yen can pull the Japanese economy out of its multi-decade torpor.
Fixed incomeBy James Kochan
Except for investors in the high-yield and municipal income markets, March was an uneventful month. Total returns for the Treasury market and those sectors closely associated with Treasuries were close to zero. Treasury returns were quite negative during the first half of the month, but then the crisis in Cyprus sparked a modest international flight to safety and the Treasury market recovered. The yield on the 10-year note ended the month exactly where it was at the end of February but 10 bps higher than it was on December 31, so quarterly returns were negative for the longer Treasury notes and bonds as well as for Treasury inflation-protected securities. The same was true for the top-quality corporate sectors. Because spreads to Treasuries were only so-so for the AAA to A credits, those sectors had modestly negative returns last quarter. In the BBB sector, where spreads were still generous, the quarterly return was 0.32%.
The mortgage market did not outperform the Treasury market last quarter because spreads to Treasuries remain narrow. The Fed’s purchases of $40 billion per month in a market where net issuance is close to zero keeps spreads narrow but also keeps the market for mortgage-backed securities unusually sensitive to any rise in Treasury yields.
It is not unusual for municipal market yields to rise somewhat in March, as new-issue calendars are typically heavy and investors often sell bonds or mutual fund shares in preparation for the April tax date. Yields increased 10 to 20 bps in the month, with the greatest increases in the A and BBB sectors. For the quarter, however, the returns from the A/BBB credits were, on average, double the returns from the AAA/AA sectors.
The high-yield market continued to rally through the quarter, with the weakest credits performing best. In March, the CCC and weaker credits outperformed the BB credits by 105 bps. For the quarter, that differential was almost 350 bps. As of this writing, yields in the BB and B sectors were approximately 10 bps above January’s record lows. In the CCC sector, yields were at the lows for this cycle and only slightly above the record lows reached in 2007. Yield spreads between the CCC and BB sectors were still generous by past cyclical standards, which is one reason why demand for the weaker credits remained strong.Fears that the great rotation from bonds to stocks would decimate the fixed-income markets have thus been unfounded. Equity mutual funds saw good inflows last quarter, but bond funds did not experience meaningful outflows. Municipals and high-yield corporates, the fixed-income sectors thought to be most vulnerable, continued to perform quite well—not as well as equities, but at this phase of the investment cycle, equities should be outperforming fixed income.
Table 1: Calendar year and year-to-date bond market total returns (%)
Asset allocationBy Brian Jacobsen
For investors with an investment horizon of three years or longer, we recommend a strategic overweight to equities relative to fixed income. Short-term, over the next three months, we think investors can still be rewarded by looking at higher-yielding fixed-income investments as well as growth-oriented equities.
From a valuation perspective, we think there are still opportunities, especially in a globally diversified equity portfolio, but we also believe there is reason to stay agile and manage downside risks. Eurozone and Japanese equities have performed relatively well thanks to Mario Draghi’s pledge to do whatever it takes to keep the eurozone together and Shinzo Abe’s promise to increase the BOJ’s inflation target. The way the eurozone seemed to fumble the Cyprus bank bailout and the already-rapid rise in Japanese equities makes us want to underweight exposure to those two regions for the next few months. Emerging markets could be dragged down with Europe because of the financial links between the two areas. We also think it might be wise to underweight emerging markets at this point for political reasons: The new leadership of Venezuela may try to be more assertive in South America, North Korea is a wildcard, and China’s central bank is quietly tightening monetary policy. This leaves us with a decent overweight to the U.S.
Value versus growth
The global economy is likely to grow 3.5% to 4% in real terms for 2013. It’s not stellar growth, but it’s still growth. We think investors are on high alert for the next crisis, meaning that even mediocre economic results could be surprisingly positive. As a result, we prefer looking for mispriced growth opportunities across the value/growth spectrum globally. We believe many solid prospects are in information technology, broadly defined as the way inputs are converted into outputs in a more efficient way. That argues, we believe, for investing in business-facing businesses rather than consumer-facing businesses.
Large caps versus small caps
Large-cap companies are probably better positioned for global growth than small-cap companies. That doesn’t mean small- and mid-cap companies should be ignored, only that it’s more important to be discerning about the economic exposure of a company rather than basing an investment decision on its size alone.
Fixed incomeBased on our economic outlook, we believe interest rates are likely to remain low for the balance of the year. This presents an opportunity for investors to consider taking on additional duration and credit risk, but we favor credit risk over duration risk. Provided the economy does not dip into a recession, default rates should not increase, meaning the increased yields on higher-yielding debt may provide better income to investors than the lower-credit-risk issues would.
Asset allocation summary table*Understanding the table
The shading on each chart represents the overweight or underweight for our asset allocation recommendations. The blue bar represents our recommended tactical positioning for investors with a time horizon of less than one year. The green bar represents our recommended strategic positioning for investors with a time frame of three years or longer. The light gray line represents the neutral weight, which is the percentage of market capitalization meeting the classification criteria of a broad market index.
The bottom lineWhile eurozone policymakers bumbled their way to a bailout of Cyprus, U.S. policymakers came to an agreement to fund the federal government until September 30, 2013 (the end of the fiscal year for the government). Baked into the agreement was the reduction in spending associated with the sequester (approximately $45 billion in reduced spending for the balance of the fiscal year). Next up is the debate over the budget for more permanent funding of programs. That debate will likely take a back seat to possible central bank activity in Europe and Japan in the first week of April. It will also be pushed further behind the headlines related to North Korea’s threats against the U.S. and South Korea. Venezuelans will be going to the polls to vote for a new president to replace the late Hugo Chavez. Italians may be getting ready to go back to the polls this summer, and Iranians will be voting for a president in June. Spring is here, but it’s not all clear skies for the markets.